From Chapter 1

Research on Safe Withdrawal Rates

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JWR1945
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From Chapter 1

Post by JWR1945 »

From Chapter 1

This blends some information from ElSupremo's featured book by John Bogle and a simple point put forth by mannfm11.

Looking at the numbers in Figure 1.2 and the corresponding table on stock returns, I have concluded that the table shows annualized returns as opposed to averages.

[In particular, the Figure shows an increase in real dollars of a $10K stock market investment in 1802 to $5589450K (or $5.589 billion) in 1997. That is an annualized return of 7.02215% over 195 years. (I.e., 1.0702215^195 = 558945 = $5589450K / $10K.) The table reports a total real return of 7.0% with dividends reinvested (and without taxes and fees). If we were talking about an average of annual returns, the number would be higher.]

The table reports a 7.2% total real return from 1926-1997 and a total real return of 12.8% from 1982-1997. John Bogle identifies the long-term return as a return on investment and any shorter fluctuation as being a return from speculation.

When we calculate annualized returns, the formula for N years of investment is (1+r)^N = Balance after N years / Balance at the beginning, where r is the annualized rate of return.

A total return of 7.2% over 50 years means that the balance after 50 years is 32.33994 times the initial balance. A total return of 12.8% over 15 years means that the balance after 15 years is 6.0902693 times the initial balance.

Assuming that we actually reach a total real return of 7.2% over 50 years when starting from 1982 (instead of 1926), the subsequent 35 years will satisfy this equation:
Balance at 50 years / Initial Balance = (Balance at 15 years / Initial Balance)*(Balance at 50 years / Balance at 15 years)
and
the numbers will be 32.33994 = (6.0902693)*(Balance at 50 years / Balance at 15 years).

The 35 years starting from 1998 would have an annualized real return r of (1+r)^35 = (Balance at 50 years / Balance at 15 years) = (32.33994/6.0902693) = 5.3101008. Solving, (1+r) = 1.0488593 and r = 4.88593%.

mannfm11 pointed out that if you have a bond with a coupon at 10% and if it is ahead by 17% at this moment, you will lose today's 17% gain when you hold the bond to maturity. To the extent that the stock market is similar to a bond starting in 1982 that yields 7.2% to maturity at 50 years, we would expect to give up the earlier 12.8% return in the 35 years starting in 1998. That would require a 4.89% real total return from 1998-2033.

When you look deeper into the issue, you will find that mannfm11 has provided the source of the return on investments as dividends and dividend growth. They provide the basis of an intrinsic value calculation. Earlier gains have had a strong component from the expansion of price to earnings multiples. That component provides the basis of the return from speculation. We would expect the multiples to come down since, otherwise, people would not be paid for stock market risk. Assuming that John Bogle's observation that the stock market's real total return is predictable over the very long-term (i.e., 50 years or more) still holds, one should plan on using 4.89% when making projections for 1998-2033. One should not plan on using anything close to 7.2%.

Have fun.

John R.
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BenSolar
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Post by BenSolar »

JWR1945 wrote:Assuming that John Bogle's observation that the stock market's real total return is predictable over the very long-term (i.e., 50 years or more) still holds, one should plan on using 4.89% when making projections for 1998-2033. One should not plan on using anything close to 7.2%.
The 4.89% you derived is significantly over the current Gordon Model prediction of 1.6% dividend yield + roughly 1.5% real growth = 3.1% predicted real return over the long term. :? I believe mannfm used the more pessimistic # of 1.1% real growth for 2.7% predicted real return.

If I thought I could get 4.9% real return from the S&P 500 I would be quite happy. I don't think I can without additional speculative return. Any thoughts on the discrepancy?

Regards,
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
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Post by JWR1945 »

Remember that John Bogle's observation was for the really long-term.

How about this scenario? Stocks face one really bad decade that brings P/E10 below its typical level, possibly to 12 or lower. Follow that by another bad decade, but not quite as bad. Follow that by a hot market in 2023-2033. That would be typical, but do not put too much emphasis on the number of years for each phase.

That is, I expect the bubble to deflate completely and then continue down as potential investors to overreact. With a prolonged period of poor returns in the stock market, I would expect an meaningful risk premium to appear once again.

You are talking in terms of today's dividend yield of 1.6%. Cutting prices in half would push the yield to 3.2% if the dividend amount were to remain constant. That would get P/E10 down to the typical range, not the bargain range. Even then, the intrinsic value if there were no risk premium would be 3.2%+1.5% = 4.7%. In addition, the payout percentages (from earnings to dividends) might increase. With an overreaction (or an ?undershoot? of prices) dividend yield could return to a favorable range.

When you look deeper into mannfm11's arguments, he has shown that the combination of random walk, efficient market and allocation theories eventually become logically inconsistent when they are put into practice by the general public. If you really could diversify all risk out of a portfolio via allocations and if prices really didn't matter because the market is always correct (or in weaker forms), the risk premium would disappear entirely, never to return. Something has to give when people are willing to pay a zero risk price for a combination of risky securities.

John Bogle's emphasis on the really long-term allows for speculative distortions to play themselves out.

Have fun.

John R.
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Post by BenSolar »

JWR1945 wrote:Remember that John Bogle's observation was for the really long-term.
As are predictions from the Gordon Equation.
How about this scenario? Stocks face one really bad decade that brings P/E10 below its typical level, possibly to 12 or lower. Follow that by another bad decade, but not quite as bad. Follow that by a hot market in 2023-2033. That would be typical, but do not put too much emphasis on the number of years for each phase.
...

You are talking in terms of today's dividend yield of 1.6%. Cutting prices in half would push the yield to 3.2% if the dividend amount were to remain constant. That would get P/E10 down to the typical range, not the bargain range. Even then, the intrinsic value if there were no risk premium would be 3.2%+1.5% = 4.7%.
But then you are talking about returns from levels 1/2 of current levels, which will obviously be higher than from current levels, no? We are talking about returns from current levels, aren't we. BTW, Jan 1998 featured dividend yield almost the same as now.
When you look deeper into mannfm11's arguments, he has shown that the combination of random walk, efficient market and allocation theories eventually become logically inconsistent when they are put into practice by the general public.
I'm afraid I don't agree that there is so much 'shown' by mannfm's posts. What I've seen him do is assume that all people who apply these theories are all making the 'past returns = future returns' error. Which isn't necessarily the case. Raddr, for instance, applies the theories in his work, but generates his expected returns using the Gordon equation type estimates. MPT isn't dead, it is just evolving. :)

Still wondering where the large discrepancy comes from. When I've looked at Gordon model predictions as opposed to actual results in the past, they were pretty close, with variations fairly clearly seen to be changes in valuation.

Regards,
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
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Post by JWR1945 »

But then you are talking about returns from levels 1/2 of current levels, which will obviously be higher than from current levels, no? We are talking about returns from current levels, aren't we? BTW, Jan 1998 featured dividend yield almost the same as now.
The 4.89% number applies only when you look at 2033 (specifically at 1998 and 2033). There are lots of ways of getting there. The least likely is a steadily growing 4.89% real total return.

My best guess is that you will see sharp reductions in prices before then.

If you want to talk in terms of current levels, assume that prices stay constant for two decades. I think that we will see today's prices at least once more sometime in the neighborhood of 8-20 years from today. Real prices will have fallen sharply. Dividend amounts will grow at inflation plus 1.1% annually (roughly speaking). (Earnings will grow faster.) That sets up the conditions needed for a hot market.

When you apply the Gordon model, be careful about the time frame. People who use the Gordon generally do not stop there. The model gives you an estimate of the (fairly priced) intrinsic value. Most people continue by adding adjustments for the speculative component (P/E expansion and contraction).

Have fun.

John R.
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Post by RobBennett »

I'm afraid I don't agree that there is so much 'shown' by mannfm's posts.... MPT isn't dead, it is just evolving.

Even that is a breakthrough insight, in my view. Say that five years from now, the consensus is that Modern Portfolio Theory is not dead, but has evolved into something very different from what most people understand it to be today. Shouldn't we be grateful to mannfm11 for having brought us that insight before it was being published in the newspapers or magazines or aired on the radio or television programs?

What I love about the internet discussion board as a new communications medium is the possibility it opens up for people to learn new things, things that most of the grand experts with their six-figure salaries have never heard tell of yet. I see it as a huge plus that discussion board posters don't need to work their way through a peer-review process prior to having fellow community members hear their insights.

Is there at some point a need for a peer-review process to make sure the insights check out? Of course. My hope and expecation is that there are dozens of ideas that have been put forward during the course of the Great SWR Debate that at some future time will be scrutinized for purposes of seeing whether they stand up to the standards needed for peer-review publication. Most likely some of the ideas will stand and some of the ideas will fall. That's for later.

For now, the important thing is to get the ideas out there so that community members can think them over and determine for themselves whether they should be making any adjustments in their investment strategies as a result of what they have learned from their consideration of the new ideas.

Mannfm11 didn't tell us about something he read in a magazine. He did his own thinking. He did his own research. He wrote up his own conclusions. He did that for us. He helped us out in our quest for early financial independence, and he wasn't paid a dime for doing so. He did it out of love for the learning experience.

If it turns out that Modern Portfolio Theory is dead, I am in the debt of Mannfm11. If it turns out that Modern Portfolo Theory is just evolving, I am in the debt of Mannfm11. The thing I am focused on for now is not how it turns out, the thing I am focused on for now is what has already happened. What has already happened is that I have learned something. We wouldn't even be having this discussion about whether MPT is dead or just evolving had Mannfm11 not put the question on the table.

I say all this not so much for Mannfm11's ears, by the way. I have told him by e-mail how grateful I am for his contributions, so he already knows. I say it for the benefit of any Mannfm11's out there today who until now have been reluctant to speak out on this issue given the unfortunate tone of much of the discussions. I want to hear the ideas that are not yet written up in peer-reviewed journals but which show the promise of changing how I think about investing for the remainer of my days on this planet.

If there are any other potential Mannfm11's out there with insights of even one-tenth of the power of those that he has already blessed us with in his short posting career here, please speak up. We all would benefit from hearing what you have to say, in my humble opinion.

My future and the future of my family is riding on me getting this stuff right. I want to hear it all.
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Post by BenSolar »

JWR1945 wrote:The 4.89% number applies only when you look at 2033 (specifically at 1998 and 2033).
And that is just because you chose 1982 as the start date for your thought experiment: from 1982 you asserted that 7% real returns were expected for the long term, and as an example of that long term you chose 50 years. Am I correct? You could have chosen 60 years and 2043 just as well right? Because it is a generic long term prediction. Just like the Gordon model prediction.
There are lots of ways of getting there. The least likely is a steadily growing 4.89% real total return.
Ups and downs in the interim do not change the fact that we have 2 very different estimates of long term return here. 2% of real return is a pretty wide gap, and I am still curious about the difference.
When you apply the Gordon model, be careful about the time frame. People who use the Gordon generally do not stop there. The model gives you an estimate of the (fairly priced) intrinsic value. Most people continue by adding adjustments for the speculative component (P/E expansion and contraction).
Yes, I'm familiar with adding a speculative component ... but that's just speculation. Smile I'd rather talk about the long term where the speculative component becomes less and less important. If I were inclined to add a speculative component to a Gordon equation prediction of returns from valuation levels like in 1998 or 2004 then I would be inclined to make that a negative adjustment. Which takes us even further from your 4.8%!

In the past we have talked about adjusting current Gordon type predictions upward a bit to account for the relatively low payout of dividends compared to earnings currently. But that is questionable. BTW the Gordon prediction for 1982 matches your 7% figure pretty well. Hmm ... I just looked at the payout percentage of 1982: Dividends/earnings, and it was surprisingly low: 43.9%. 1998 was only a little lower at 39.2%. Currently it is even lower at 35.2% (per S&P's figures for trailing 12 month dividends and 'as reported' earnings).

Regards,
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
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Post by BenSolar »

RobBennett wrote:Say that five years from now, the consensus is that Modern Portfolio Theory is not dead, but has evolved into something very different from what most people understand it to be today. Shouldn't we be grateful to mannfm11 for having brought us that insight before it was being published in the newspapers or magazines or aired on the radio or television programs?
You are welcome to give mannfm all the credit in the world, but I haven't seen too much to get in such a lather about. Nobody really thinks that financial theory has been in stasis since MPT was proposed in the 1950s, do they? Here's an overview of the history of financial theory. Surprisingly it goes past 1960. :)
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
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Post by RobBennett »

You are welcome to give mannfm all the credit in the world, but I haven't seen too much to get in such a lather about.

OK, BenSolar.

I think it is fair to say that I am by nature a get-in-a-lather sort of guy. So perhaps we are just talking about a matter of personality differences here.

The bottom line for me is that I think that mannfm11 has revealed himself to be a Giant in the history of FIRE discussion boards with the few posts he has put forward here in recent weeks. You are a Giant too, in my estimation. And I am glad to see you making the effort to subject the mannfm11 claims to the sort of scrutiny that must be applied if community members are to make use of them in developing their personal investment strategies.
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Post by JWR1945 »

BenSolar
And that is just because you chose 1982 as the start date for your thought experiment: from 1982 you asserted that 7% real returns were expected for the long term, and as an example of that long term you chose 50 years. Am I correct? You could have chosen 60 years and 2043 just as well right? Because it is a generic long term prediction. Just like the Gordon model prediction.
No!
The title of this thread is From Chapter 1 and it refers to the book by Bogle that ElSupremo has recommended. The time periods that I have used are those that Bogle has identified in his book. The only exception is the ending date associated with 1982. Bogle presented fifteen year data for 1982-1997. I extended it to the 50 years that Bogle uses for his segments. (He does not use exactly 50 years in each case, but 50 years is very close and much closer than 40 years or 60 years.)

The Gordon equation, suitably modified, appears in Chapter 2. John Bogle uses earnings growth instead of dividend growth and I am comfortable with that change. Earnings growth is more predictable (provided that you smooth it) than dividend growth. In particular, the payout ratio has decreased in recent decades. Although the details are somewhat arguable, growth has picked up to compensate. [The unresolved issue is whether is has picked up enough to compensate entirely or whether it is something less.] That pick up in earnings growth means that dividend amounts should grow faster as well, except to the extent that the payout ratio decreases even further.

Bogle uses 10 year time periods to present his (modified Gordon equation) data. I believe that he uses a single year's trailing price to earnings ratio when adjusting for multiple expansion and compression. I am interested in looking at something similar, but using earning yield from 1/[P/E10]. I expect it to capture the investment components (of dividend yields and earnings growth) very well. I will have to look at the data to see how well it handles the speculative component (of multiple expansion and contraction).

[As an aside, when I first started to look at earnings yield (as measured by E10/P) for estimating portfolio survival rates, I looked the Historical Database Rate minus the initial dividend yield for the y axis and earnings yield E10/P on the x axis. It was only later that I simplified matters and got better curve fits. Earnings yield (from E10/P) has smoothed earnings. Smoothed earnings seem to eliminate the surprise drops in dividend yields occasionally seen in the past. That is, if the earnings yield won't support a dividend, the dividend will fall.]

In terms of the Gordon equation and its adjustments, what I have seen is generally related to the middle term, in the neighborhood of ten years. I would be very concerned about its accuracy over longer time periods because dividend payout ratios vary with time and because the dividend yield is dependent upon initial valuations.

It is Bogle who has emphasized the stability of stock market (real) total returns over very long periods (of 50 to 195 years). Bogle allows for the possibility that the long-term growth rate may have increased permanently in recent years, but I have not made any adjustments along those lines.

Bogle has written and ES has recommended a book well worth reading.

Have fun.

John R.
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Post by BenSolar »

JWR1945 wrote:In terms of the Gordon equation and its adjustments, what I have seen is generally related to the middle term, in the neighborhood of ten years. I would be very concerned about its accuracy over longer time periods because dividend payout ratios vary with time and because the dividend yield is dependent upon initial valuations.
I've usually seen the Gordon equation used as a predictor of long term returns. Shorter terms like 10 years are overly dominated by speculative return to be terribly predictable, though it may be long enough for modest predictive effect.

Bernstein from Efficient Frontiers:
http://www.efficientfrontier.com/ef/901/factors.htm
the Gordon Equation, which stipulates that long-term stock returns are the same as the average dividend yield plus the dividend growth rate.
http://www.efficientfrontier.com/ef/701/cheap.htm
The best prediction of asset-class returns probably comes from simply adding the coupon or dividend rate to the dividend- or earnings-growth rate. (This is referred to, somewhat grandiosely, as the "Gordon equation" and falls out of the discounted dividend model.) John Bogle calls this simple sum the fundamental return. Unfortunately, in the short term this estimate often gets thrown for a loop by changes in asset-class multiple (or in Bogle's lexicon, by the speculative return). For example, if an asset valuation doubles in the space of a year, then that asset's return will be about 100%, since this will dwarf the contribution of the dividend and growth sum. But over long periods of time, the speculative return washes out, leaving only the fundamental return.
So, like Bernstein, I equate expected fundamental return and the Gordon equation prediction. We can't just start from a random stock price/valuation and say that we expect 7% real return over the very long term. Of course you know that. :?

I haven't read Bogle's 'Common Sense' yet. It is on my reading list. I have read most of his essays/speeches/interviews that are available on the internet from the last several years, though, so I think I have a pretty good grasp of his point of view.

Regards,
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
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